Subject: Derivatives - Futures on a Single Stock

A single-stock future is a contract to buy or sell 100 shares of a
single stock on a future date at a price locked in when the contract
is established. A single-stock future (SSF) falls in the category of
Securities Futures, together with futures on ETFs and narrow index
(two to nine stocks) futures. This article focuses on the
single-stock futures contracts that trade on the OneChicago Exchange
in the U.S. These securities began trading in 2002 but they are not
yet widely known.

Like stock options, single-stock futures are structured as units
called "contracts," each of which controls 100 shares. The
single-stock futures traded on the OneChicago exchange are physically
settled (not settled to cash). That means that actual shares change
hands upon expiration. So a trader who buys a single contract and
holds it to expiration agrees to take delivery and pay for 100 shares.
A trader who sells a single-stock future (i.e., who opens a new short
position) agrees to make delivery of 100 shares upon expiration.
Unlike stock options, no "strike price" is associated with a
single-stock futures contract.

Like commodity futures, a single-stock futures contract carries both

the right and the obligation to take delivery or to deliver the stock
on the expiration date. Also like commodity futures, purchase or sale
of a single-stock future locks in today's price of that stock. A
trader who holds a futures contract (i.e., who is long) does not
collect stock dividends, and a trader who sold a futures contract
(i.e., who is short) is not obligated to pay stock dividends.

Like all futures contracts, single-stock futures contracts have an
expiration date. At any one time approximately four expiration dates
are available. These generally follow the quarterly cycle of March,
June, September, and December. The expiries for the longest-term
contracts range from six to eight months, depending on the time of the
year.

Single-stock futures can be traded freely prior to their expiration
dates, and pricing of the contracts varies according to supply and
demand. The performance of single-stock futures contracts tracks the
performance of the underlying stocks almost exactly, with a couple of
caveats. For a long position, the price of this futures contract is
generally equal to the current stock price, discounted for any
dividends that are scheduled to occur prior to the expiration date,
plus interest according to prevailing rates. Similarly, for a short
position, the price is the current stock price, minus any dividends to
be paid, plus interest. Unexpected changes in stock dividend payments
can cause the performance of a futures contract to vary from the
underlying to a certain extent. Thus, these contracts will never
be a 100% perfect analog to the shares themselves.

Single-stock futures are typically traded on margin. Brokers
generally require only 20% of the value of the underlying to be put up
as collateral. Thus these securities can easily be used to create
leveraged positions.

If you like to sell stocks short, you may want to consider selling a
single-stock futures contract instead. Why is this? Because
selling short has a number of disadvantages. For most stocks you must
wait for an uptick in the price before you can enter the position
(although some stocks have recently been exempted from this
requirement). Then you must borrow the stock. If there's no stock
available to borrow, you're out of luck. Further, if the stock moves
against you and you don't have enough cash in your account to cover
the loss, you will have to pay margin interest on the excess for as
long as you hold the position.

Selling a single stock future contract eliminates these problems.
There is no need to wait for an uptick or borrow the stock. And
instead of potentially having to pay margin interest, you collect
interest on the position. Lastly, only 20% of the price is tied up in
margin. You can invest some or all of the remainder in a safe income
instrument and collect even more interest. However, unlike a short
position that can be kept open more or less indefinitely, a contract
eventually expires.

Futures can also be helpful for tax management. Say you hold an
appreciated position in a stock which you would like to sell, but you
don't want to pay short-term capital gains taxes. You can instead
sell a single stock future contract for the stock and lock in your
return. You can then wait until the long-term capital gain cutoff,
collecting market interest on the size of the position in the
meantime. Once the minimum holding period has passed, you liquidate
both positions, and collect your short-term profits while paying
long-term capital gains tax. Since the future contract is a
near-perfect analog to the underlying stock, you are protected from
any losses while you wait. Of course there is a caveat: if the stock
drops precipitously while you are holding, you might end up having to
pay short term taxes on your profit from your short future position.
No strategy is perfect, but it beats losing your gains.

Another common technique is to use futures to create "matched pair"
positions. The matched pair strategy is a way of betting on the
relative performance of two companies in the same industry. For
example, say you think AMD will outperform INTL. You can buy AMD
contracts and sell an equal dollar amount of INTL contracts. If AMD
does better than INTL, you profit. If not, you will lose money. The
interesting thing to note here is that you are protected from a number
of risks many investors face. For example, if there is a collapse in
the computer chip industry at large, it is likely that both AMD and
INTL will suffer. You will likely remain unaffected, as their
relative performance will remain unchanged. The same applies
to a broad stock-market crash. Also, note that the interest component
of the contracts cancel out, so you are protected from shifts in
interest rates.

Single-stock futures have many other uses for creative investors.
The OneChicago web site offers more detail:
http://www.onechicago.com/.